Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.

One of the smartest people I know—a brilliant copy editor—used to shake her head as she read articles about bonds and the bond market.

“I think you have to be born with the bond gene to understand bonds,” she would mutter.

What set Mary to muttering, as I recall, was the fact that bond prices tend to move in the opposite direction of interest rates.

“You would think,” she’d say, “that higher interest rates would be good for bond investors. Wouldn’t I earn more?”

Was she in need of a bond-gene transplant? Not really. The impact of rising or falling rates on bond returns varies depending on time horizons.

The short term

When interest rates go up, the market value, or price, of an existing bond immediately falls. This adjustment occurs because an investor wouldn’t pay full price for an existing bond with a face value of $1,000 and a yield of 4% if she could get a similar $1,000 bond yielding 5%. It’s the opposite story when interest rates fall. If prevailing interest rates go from 5% to 4%, you’d expect to pay more for the existing 5% bond than for one yielding 4%.

So in the short run, rising interest rates are bad news and falling rates are good news for an investor who holds bonds or bond funds.

The long term

But over the longer term, rising interest rates can be good for bond investors. And falling rates, although they boost bond prices at first, eventually are not so good for bond investors.

The key is what happens over time as your bond investments throw off income and as bonds mature. The income from your bonds is either spent or reinvested. If you reinvest the income, and rates have gone up, that $100 earns more than if rates fell or held steady. And when a $1,000 bond you own (directly or in a bond fund) matures, you’d rather be able to reinvest that $1,000 in principal at, say, a 6% yield than at 4%. At 6%, money doubles in roughly 12 years. At 4%, it takes about 18 years to double.

For long-term bonds, it’s the interest income—and the reinvestment of that income—that accounts for the largest portion of total returns. Over time, the impact of price fluctuations is outweighed by the impact of reinvestments of income and principal.

The table below illustrates the disparate impact of rate changes over various periods, demonstrating how important an investor’s time horizon is when thinking about the risks of interest rates. For the long-term investor, the bigger risk is lower rates, not higher rates. The reverse is true for the short-term investor.

This element of time is too often missed, I think, in commentary on bonds and in the way some investors think about bonds. For example, bond mutual funds tend to attract increased cash from investors after interest rates have fallen and prices have appreciated—as reflected in cash flows during 2009. After periods of rising interest rates—when bond prices have fallen and bond fund returns are weak or negative—it’s not unusual to see money flowing out of bond funds.

It’s as if investors have a genetic inclination to use the rear-view mirror to guide them in moving forward.

Are there terms or concepts about bonds and bond investing that you find puzzling? Yield curves? Duration? Credit risk and credit spreads?

I’d be interested in hearing about them, then asking some of our bond experts to tackle the questions in a future post or posts.

Like this:

Craig Stock

Craig Stock heads Vanguard's Corporate Marketing and Communications department, responsible for delivering investor information and education in Vanguard’s "plain talk" style.
Before joining Vanguard in 1995, Craig spent two decades in journalism. At The Philadelphia Inquirer, he reported on business and the economy, served as a business editor, and wrote a column on personal finance.
Craig holds a B.S. from the University of Kansas, and was a Sloan Fellow in Economics Journalism at Princeton University's Woodrow Wilson School. He’s also the author of Investing During Retirement, published in 1997.

Comments

Anonymous | April 9, 2010 1:28 pm

Anonymous | April 8, 2010 1:58 pm

The part about investing in bonds I never have been able to grasp is the coupon or discount rate. I’ve read and re-read about coupon rates, and just can’t wrap my mind around the concept. As a result, I stick to bond funds and stay clear of purchasing individual bonds.

Anonymous | April 5, 2010 2:27 pm

i’m retired.. got an investment plan from Vanguard 4 years ago… i have been buying and increasing my bond funds up to the targets. i only started doing that in the past 18 months. ’cause i thought that owning bonds was, well dull. so i had a lot in CD’s and they matured and i couldn’t buy MORE stocks and yields on CD & Money Markets were so low … i became a bond investor, yeah the accidenal bond investor, but i still think i could time the market… but not with my IRA $… so yeah they are dull.. but if i had followed the plan i got in 2006 ( sooner ) i would have more $ now.
So i bought the bond funds that were recommended, at what i thought were discounted / distressed prices ( oh yeah i can time the market ) but i’ve learned ( the hard way ) to stay the course and be diversivied, yeah just like what Vanguard sez on every page

Anonymous | March 8, 2010 1:05 pm

Anonymous | February 17, 2010 5:10 pm

You asked for questions. If I plan to invest $20,000 per year in a Vanguard bond and $50,000 per year in a balanced Vanguard equity fund over a thirty year period until I retire, then possibly take out current bond fund income but no principal during my retirement, should I invest in a long term fund or an intermediate term fund?

Anonymous | February 12, 2010 11:57 am

I am an individual who began investing in 1968. Commit for the “long term” or invest only in short-term or intermediate term bonds. My wife buys individual stocks. I invest only in mutual funds: Stock Funds, Bond Funds, and Balanced Funds. Thank you!

Anonymous | February 7, 2010 6:32 pm

There is one thing I do not understand about bond funds. Since they never mature, how do you know that you will get your investment back? In a rising interest rate environment, it seems like the bond value would continue to decline, even though you may be getting higher yields. If you ever need to sell (say for retirement needs), the bond fund value would be lower than what you paid. If you own the bond outright (vs a fund), this would not happen. So why own a bond fund?

Anonymous | February 7, 2010 6:26 pm

I have a fair amount of cash to invest and would like to diversify more into bonds. However, the low interest rate environment that has been continuing has me sitting on the sidelines. I feel that if I invest now, I am certain to suffer a loss. Should I hold onto my cash (earning almost zero) and wait for interest rates to rise before investing? How do I know when the “right” point is? I am not a market timer, however it does not seem to be prudent to invest in bonds now when rates are at historically low levels.

Anonymous | February 4, 2010 6:20 pm

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.